Friday, July 8, 2011

The debt ceiling limit: Dean Baker vs. Matt Rognlie

So I have been having a back and forward with Matt Rognlie on his blog about Dean Baker’s proposal to destroy the 1.6 trillion dollars in the Fed balances as a way of avoiding the debt ceiling limit. Note that, as Dean says, this debt is owed by one branch of government to the other (although the Fed is a hybrid part public, part private), and is basically owed to itself. The point is that nobody loses if the Fed just shreds the bonds. Dean then discusses the risks of doing it, which are fundamentally associated with the loss of the bonds (which the Fed could sell to the public to reduce liquidity) and the effects that it might had in future monetary policy. The fear was (although I doubt that was Dean’s concern) the Fed would have its ability to curtail liquidity limited and that inflation pressures might not be contained. Dean simply noted that reserve requirements could be used in that case.

Not a difficult point to make. Rognlie suggests somehow that this is both confusing and not serious. To prove it he assumes that the Fed would need to reduce liquidity by the same amount of the bonds destroyed (and, hence reducing almost the whole increase in liquidity that the Fed was forced to do as a result of the crisis), which he notes would be impossible. The question is why would someone assume something like that, and the only explanation is that he must believe that there is a fixed relation between liquidity and prices (a fixed velocity of money) and that to avoid inflation the same amount of money that was created will have to be destroyed. But that seems to be a very strong assumption to make. Since there is a lot of unused capacity it is far from clear that the Fed needs to increase the reserve requirements at all. So in all fairness there are NO consequences of destroying those bonds. And, as noted by Dean, yes it is just an accounting gimmick to get around the accounting stupidity of the debt-ceiling. It might not have a chance in the current policy debates (since Democrats have a tendency to cave on almost anything), but is a perfectly logical solution.

7 comments:

To be honest, I don't understand your musings about "liquidity" and "prices" at all; we might as well be speaking a different language. I don't think that your implicit framework for thinking about monetary policy is quite right---there seems to be a lot of hand-waving about the relationship between "liquidity" and "inflationary pressures"---but it's hard to say much, since I don't understand it.

Here I copy part of my response from back at my blog:

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Since we are discussing issues that are ultimately quantitative, perhaps I should provide an explicit quantitative example. (The numbers are not meant to be exactly right; they're just to illustrate the conceptual point.) Suppose that the Fed has $3 trillion in assets, of which $1.5 trillion are Treasuries. (For simplicity, let’s suppose that all assets pay the same as T-bills. Since the Treasury assets are mostly long-duration assets, and the non-Treasury assets are mainly MBS, this is not quite true without adjusting for risk and duration, but it’s not so far from the truth either.) The Fed also has $3 trillion in liabilities. Under the existing schedule of reserve requirements and currency demand, the maximum supply of base money that is consistent with the FFR being greater than IOR is $1 trillion (of which reserves will be a very small portion); otherwise, base money will be in such excess that it will no longer carry any liquidity premium, and the FFR, the IOR rate, and T-bill rate will all be roughly the same. (As they are now.)

The Fed plans to return to the usual situation of FFR > IOR, which means selling $2 trillion in assets and removing $2 trillion in liabilities, until it hits the $1 trillion mark where a liquidity premium reemerges. To be concrete, let's suppose that in this case it sells off all its Treasury debt. (Its choice about what asset to sell doesn't actually matter as long as the assets are priced fairly.)

Now suppose that it destroys the $1.5 trillion in Treasuries. Now it has $3 trillion in liabilities and only $1.5 trillion in assets. Obviously it can't get all the way down to $1 trillion in liabilities; it's insolvent and doesn't have the assets to sell. How low can it go? Well, it needs to retain some assets. For the sake of argument, let's suppose that it's risk-loving and is willing to tolerate $500 billion in assets backing $2 trillion in liabilities. (Only 25%!) It sells $1 trillion in assets to reach this point.

Now we still have $2 trillion in liabilities. That's way more than $1 trillion, which is the level necessary for a liquidity premium to emerge and to have FFR > IOR. If the situation stays this way, there is no fiscal benefit.

Why? Well, the previous plan was for the Fed to pay interest on $1 trillion in liabilities while gathering returns on $1 trillion of non-Treasury assets, and for the Treasury to pay interest to some external party on the $1.5 trillion of its bonds that the Fed sold. Ignoring the Treasury's other debt, the net position of the Fed is $0 (though it has seignorage revenue from the fact that its liabilities pay less than its assets), while the net position of the Treasury is -$1.5 trillion.

Alternatively, if we destroy the $1.5 trillion in Treasuries, the Fed is now an additional $1.5 trillion in the hole, while the Treasury is up to $0. Does the Fed pay less interest on this $1.5 trillion than the Treasury would have paid on it? Not at all! To be explicit, let's write:

It's the same result---you pay the prevailing interest rate (which I write as the FFR%) on the part of your debt that is not cash or interest-free reserves. (In fact, the second situation is slightly worse, since the Fed is not actually paying 0% on the full $1 trillion; a sliver of that is supposed to consist of reserves as well.)

How do we alter this result? Well, we can't convince the public to hold more cash without lowering the trajectory of the FFR, which in the long-run must mean lower steady-state inflation; even then, their demand is pretty inelastic. Our only real option here is to change the reserves from "interest-paying" to "interest-free". But conditional on a particular trajectory for the FFR%, the only way to do this is to raise the reserve requirement so much that a liquidity premium reemerges. For this to happen, we need to create $1 trillion in additional required reserves. And that is what Dean Baker doesn’t seem to understand.

Yes we are talking different languages. Mine is economics. But there again I wasn't brainwashed by mainstream ideologues. If you need a dictionary I can suggest a few readings. But I doubt you really want to understand economics. You probably just want a good job within the profession. My mistake thinking that dialogue was possible.

Prices refers to the general price level. Liquidity some measure of money supply. Still if you don't get that destroying the bonds has no effect on the economy, or the ability of the Fed to control the rate of interest, there is nothing else to talk about.

"Prices refers to the general price level. Liquidity some measure of money supply. Still if you don't get that destroying the bonds has no effect on the economy, or the ability of the Fed to control the rate of interest, there is nothing else to talk about."

I must have been extraordinarily ineffective at making my point, because I actually don't disagree with this. I do disagree with the assertion that destroying the bonds would be fiscally beneficial.

At best, if you engineer a massive increase in reserve requirements (and I mean massive), you can earn more revenue from the liquidity premium---but this is just a tax on bank deposits, one that could also be administered explicitly. And there is no need whatsoever to destroy the bonds (which are just a transfer from one part of the government to another) to obtain this revenue.

Let's go back to your post:

"To prove it he assumes that the Fed would need to reduce liquidity by the same amount of the bonds destroyed (and, hence reducing almost the whole increase in liquidity that the Fed was forced to do as a result of the crisis), which he notes would be impossible."

Look: if the reserves stay out there at current levels, there will be no liquidity premium on reserves. As a result, the interest rate paid on reserves will be roughly the same as the rate on T-bills, and there will be no benefit from issuing debt in the form of money rather than bonds. This is true no matter what trajectory of monetary policy the Fed decides to choose. (When there are excess reserves, it still has the freedom to set monetary policy by adjusting the rate paid on reserves.)

"The question is why would someone assume something like that, and the only explanation is that he must believe that there is a fixed relation between liquidity and prices (a fixed velocity of money) and that to avoid inflation the same amount of money that was created will have to be destroyed."

No! You either haven't read what I've written or are replacing me with some monetarist caricature from an old textbook. (Which is extraordinarily inaccurate, given what I've written.) I've intentionally tried to make the analysis as simple and as free from assumptions concerning the economic effects of monetary policy as possible. I'm simply saying that when reserves are at such a high level, the liquidity premium (which determines the Fed's seignorage income from reserves) disappears; I can't imagine many economic statements more theoretically and empirically indisputable than that.